Income Taxation of Note Investments

The interest rate is 12%. I collect interest for the year of $1,200 and principal of $1,000 in the first year. How do I report the $1,000 principal collected on the tax return? — Bruce Moeller

At first glance, this might seem to be a complicated tax question, but fortunately for note investors there are two simple solutions. I’ll show the commonly used method first.

In your example, the note, which is an asset, was purchased at a 50% discount. As the payor makes the contractual payments, half of each principal dollar paid is your investment coming back and half is profit. So on your income tax return, with $1,000 of annual principal paid, you would show $500 of “discount earned” and $1,200 of “interest,” both of which are taxable as income. The other $500 of the cash flow is your investment coming back, termed “return of capital,” and is not taxable.

If you look at a typical two column amortization schedule for your example, principal and interest, imagine the principal column being split into two more columns, 50% of which is “discount earned” with the other 50% being “return of capital.”

To clarify with a slightly different example, assume you bought the $10,000 note at a $3000 discount, for a purchase price of $7000. As each principal dollar was collected, 30% would be taxable “discount earned” and the remaining 70% is your untaxed “return of capital.” Interest is still interest.

There is another method referenced by the IRS which is less frequently used. You did not quote a yield or a length of term in your example, so let’s just say it was priced to yield 18%. You can print an amortization schedule showing your $5000 investment at 18%. The principal column, although it won’t match the payor’s schedule, is your money coming back and the “interest” column, which also does not match the payor’s, is really your total taxable yield. The reason this is not selected often by investors — although the IRS unsurprisingly is happy for you to use it — is that more taxable income appears in the early years with more untaxable “return of capital” in the later years.

Article from The Paper Source, INC courtesy of John Moren who is the author of the NoteSmith family of loan servicing software that tracks mortgage notes, discounted notes, leases, rent, and other cash flows. www.NoteSmith.com.